1. The principal advantage of the corporate form of business
organization is that the corporation has limited liability. The
owner of a small family restaurant might be required to personally
guarantee corporate borrowings or purchases anyway, so much of this
advantage might be eliminated. The wealthy individual has more at
stake and unlimited liability might cause one failing business to
bring down the other, healthy businesses.
2. The liability is limited to the amount of the investment in both
the limited partnership and in the corporation. However, the
limited partner generally does not have a role in selecting the
management or in influencing the direction of the enterprise. On a
pro rata basis, stockholders are able to select management andaffect the direction of the enterprise. Also, partnership income
is taxable to the limited partners as personal income whereas
corporate income is not taxed unless distributed to the
stockholders as dividends.
3. With both a sole proprietorship and partnership, a major drawback
is the legal liability of the owners. It extends beyond the
financial resources of the business to the owners personally.
Fringe benefits are not deductible as an expense. Also, both forms
of organization lack the corporate feature of "unlimited life."
With the partnership there are problems of control and management.
The ownership is not liquid when it comes to planning for
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 14
individual estates. Decision making can be cumbersome. An LLC
generally lacks the feature of "unlimited life," and complete
transfer of an ownership interest is usually subject to the
approval of at least a majority of the other LLC members.
4. The chief beneficiaries are smaller companies where the first
$75,000 in taxable income is a large portion, if not all, of their
total taxable income.
5. Accelerated depreciation is used up to the point it is advantageous
to switch to straight line depreciation. A one-half year
convention is followed in the first year, which reduces the cost
recovery in that year from what would otherwise be the case.
Additionally, a one-half year convention is followed in the year
following the asset class. This pushes out the depreciation
schedule, which is disadvantageous from a present value standpoint.
The double declining balance method is used for the first four
asset classes, 3, 5, 7 and 10 years. The asset category determines
the project's depreciable life.
6. The immunity from each other's taxing power dates back to the early
part of the 19th century. It used to apply to salaries of
government employees as well. The exemption is historical, and it
is hard to rationalize from the standpoint of economic/taxing
efficiency.
7. Personal tax rates are progressive up to a point, then become
regressive.
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 15
8. With the differential taxation of ordinary income and
capital gains, securities with a higher likelihood of capital gains
are tax advantaged. These include low dividend common stocks,
common stocks in general, discount bonds, real estate, and other
investments of this sort.
9. Depreciation changes the timing of tax payments. The longer these
payments can be delayed, the better off the business is.
10. One advantage to Subchapter S occurs when investors have outside
income against which to use losses by the company. Even with no
outside income, stockholders still may find Subchapter S to be
advantageous. If dividends are paid, the stockholder under
Subchapter S is subject only to taxation on the profits earned by
the company. Under the corporate method, the company pays taxes on
its profits and then the owners pay personal income taxes on the
dividends paid to them.
11. Tax incentives are the result of special interest groups
influencing legislators. For example, exporters influenced the
passage of DISCs. Doctors and attorneys influenced the passage of
the Keogh pension plans. Some of these incentives benefit society
as a whole; others benefit only a few at the expense of the rest of
society. It is hard to imagine all individuals placing the
interest of the whole above their own interests. Therefore, it is
difficult to perceive that tax incentives will be discontinued.
Further, some incentives can be used to benefit large groups of
people.
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 16
12. The purpose of the carryback and carryforward provisions is to
allow the cyclical company with large profit swings to obtain most
of the tax benefits available to a company with more steady
profits. Also, the provision protects the company with a large
loss in a given year. While if a company has steady losses it does
not benefit from this provision, the marginal company with profit
swings does.
13. Financial markets allow for efficient allocation in the flow of
savings in an economy to ultimate users. In a macro sense, savings
originate from savings-surplus economic units whose savings exceed
their investment in real assets. The ultimate users of these
savings are savings-deficit economic units whose investments in
real assets exceed their savings. Efficiency is introduced into
the process through the use of financial markets. Since the
savings-surplus and savings-deficit units are usually different
entities, markets serve to channel these funds at the least cost
and inconvenience to both. As specialization develops, efficiency
increases. Loan brokers, secondary markets, and investment bankers
all serve to expedite this flow from savers to users.
14. Financial intermediaries provide an indirect channel for the flow
of funds from savers to ultimate users. These institutions include
commercial banks, savings and loan associations, life insurance
companies, pension and profit-sharing funds and savings banks.
Their primary function is the transformation of funds into more
attractive packages for savers. Services and economies of scale
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 17
are side benefits of this process. Pooling of funds, diversification
of risk, transformation of maturities and investment expertise
are desirable functions that financial intermediaries perform.
15. Differences in maturity, default risk, marketability, taxability,
and option features affect yields on financial instruments. In
general, the longer the maturity, the greater the default risk, the
lower the marketability and the more the return is subject to
ordinary income taxation as opposed to capital gains taxation or no
taxation, the higher the yield on the instrument. If the investor
receives an option (e.g., a conversion feature or warrant), the
yield should be lower than otherwise. Conversely, if the firm
issuing the security receives an option, such as a call feature,
the investor must be compensated with a higher yield. Another
factor -- one not taken up in this chapter -- is the coupon rate.
The lower the coupon rate, the greater the price volatility of a
bond, all other things the same, and generally the higher the
yield.
16. The market becomes more efficient when the cost of financial
intermediation is reduced. This cost is represented by the
difference in interest rate between what the ultimate saver
receives and what the ultimate borrower pays. Also, the
inconvenience to one or both parties is an indirect cost. When
financial intermediation reduces these costs, the market becomes
more efficient. The market becomes more complete when special
types of financial instruments and financial processes are offered
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 18
in response to an unsatisfied demand by investors. For example,
the new product might be a zero-coupon bond and the new process,
automatic teller machines.
17. These exchanges serve as secondary markets wherein the buyer and
seller meet to exchange shares of companies that are listed on the
exchange. These markets have provided economies of time and scale
in the past and have facilitated exchange among interested parties.
18. a) All other things the same, the cost of funds (interest rates)
would rise. If there are no disparities in savings pattern,
the effect would fall on all financial markets.
b) Given a somewhat segmented market for mortgages, it would
result in mortgage rates falling and rates on other financial
instruments rising somewhat.
c) It would lower the demand for common stock, bonds selling at a
discount, real estate, and other investments where capital
gains are an attraction for investment. Prices would fall for
these assets relative to fixed income securities until
eventually the expected returns after taxes for all financial
instruments were in equilibrium.
d) Great uncertainty would develop in the money and capital
markets and the effect would likely be quite disruptive.
Interest rates would rise dramatically and it would be
difficult for borrowers to find lenders willing to lend at a
fixed interest rate. Disequilibrium would likely continue to
occur until the rate of inflation reduced to a reasonable
level.
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 19
e) Financial markets would be less efficient in channeling funds
from savers to investors in real estate.
19. Answers to this question will differ depending on the financial
intermediary that is chosen. The economic role of all is to
channel savings to investments at a lower cost and/or with less
inconvenience to the ultimate borrower and to the ultimate saver
than would be the case in their absence. Their presence improves
the efficiency of financial markets in allocating savings to the
most productive investment opportunities.
20. Money markets serve the short-term liquidity needs of investors.
The usual line of demarkation is one year; money markets include
instruments with maturities of less than a year while capital
markets involve securities with maturities of more than one year.
However, both markets are financial markets with the same economic
purpose so the distinction of maturity is somewhat arbitrary.
Money markets involve instruments that are impersonal; funds flow
on the basis of risk and return. A bank loan, for example, is not
a money-market instrument even though it might be short term.
21. Transaction costs impede the efficiency of financial markets. The
larger they are, the less efficient are financial markets.
Financial institutions and brokers perform an economic service for
which they must be compensated. The means of compensation is
transaction costs. If there is competition among them, transaction
costs will be reduced to justifiable levels.
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 20
22. The major sources are bank loans, bond issues, mortgage debt, and
stock issues.
23. Financial brokers, such as investment bankers in particular as well
as mortgage bankers, facilitate the matching of borrowers in need
of funds with savers having funds to lend. For this matching and
servicing, the broker earns a fee that is determined by competitive
forces. In addition, security exchanges and the over-the-counter
market improve the secondary market and hence the efficiency of the
primary market where securities are sold originally.
organization is that the corporation has limited liability. The
owner of a small family restaurant might be required to personally
guarantee corporate borrowings or purchases anyway, so much of this
advantage might be eliminated. The wealthy individual has more at
stake and unlimited liability might cause one failing business to
bring down the other, healthy businesses.
2. The liability is limited to the amount of the investment in both
the limited partnership and in the corporation. However, the
limited partner generally does not have a role in selecting the
management or in influencing the direction of the enterprise. On a
pro rata basis, stockholders are able to select management andaffect the direction of the enterprise. Also, partnership income
is taxable to the limited partners as personal income whereas
corporate income is not taxed unless distributed to the
stockholders as dividends.
3. With both a sole proprietorship and partnership, a major drawback
is the legal liability of the owners. It extends beyond the
financial resources of the business to the owners personally.
Fringe benefits are not deductible as an expense. Also, both forms
of organization lack the corporate feature of "unlimited life."
With the partnership there are problems of control and management.
The ownership is not liquid when it comes to planning for
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 14
individual estates. Decision making can be cumbersome. An LLC
generally lacks the feature of "unlimited life," and complete
transfer of an ownership interest is usually subject to the
approval of at least a majority of the other LLC members.
4. The chief beneficiaries are smaller companies where the first
$75,000 in taxable income is a large portion, if not all, of their
total taxable income.
5. Accelerated depreciation is used up to the point it is advantageous
to switch to straight line depreciation. A one-half year
convention is followed in the first year, which reduces the cost
recovery in that year from what would otherwise be the case.
Additionally, a one-half year convention is followed in the year
following the asset class. This pushes out the depreciation
schedule, which is disadvantageous from a present value standpoint.
The double declining balance method is used for the first four
asset classes, 3, 5, 7 and 10 years. The asset category determines
the project's depreciable life.
6. The immunity from each other's taxing power dates back to the early
part of the 19th century. It used to apply to salaries of
government employees as well. The exemption is historical, and it
is hard to rationalize from the standpoint of economic/taxing
efficiency.
7. Personal tax rates are progressive up to a point, then become
regressive.
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 15
8. With the differential taxation of ordinary income and
capital gains, securities with a higher likelihood of capital gains
are tax advantaged. These include low dividend common stocks,
common stocks in general, discount bonds, real estate, and other
investments of this sort.
9. Depreciation changes the timing of tax payments. The longer these
payments can be delayed, the better off the business is.
10. One advantage to Subchapter S occurs when investors have outside
income against which to use losses by the company. Even with no
outside income, stockholders still may find Subchapter S to be
advantageous. If dividends are paid, the stockholder under
Subchapter S is subject only to taxation on the profits earned by
the company. Under the corporate method, the company pays taxes on
its profits and then the owners pay personal income taxes on the
dividends paid to them.
11. Tax incentives are the result of special interest groups
influencing legislators. For example, exporters influenced the
passage of DISCs. Doctors and attorneys influenced the passage of
the Keogh pension plans. Some of these incentives benefit society
as a whole; others benefit only a few at the expense of the rest of
society. It is hard to imagine all individuals placing the
interest of the whole above their own interests. Therefore, it is
difficult to perceive that tax incentives will be discontinued.
Further, some incentives can be used to benefit large groups of
people.
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 16
12. The purpose of the carryback and carryforward provisions is to
allow the cyclical company with large profit swings to obtain most
of the tax benefits available to a company with more steady
profits. Also, the provision protects the company with a large
loss in a given year. While if a company has steady losses it does
not benefit from this provision, the marginal company with profit
swings does.
13. Financial markets allow for efficient allocation in the flow of
savings in an economy to ultimate users. In a macro sense, savings
originate from savings-surplus economic units whose savings exceed
their investment in real assets. The ultimate users of these
savings are savings-deficit economic units whose investments in
real assets exceed their savings. Efficiency is introduced into
the process through the use of financial markets. Since the
savings-surplus and savings-deficit units are usually different
entities, markets serve to channel these funds at the least cost
and inconvenience to both. As specialization develops, efficiency
increases. Loan brokers, secondary markets, and investment bankers
all serve to expedite this flow from savers to users.
14. Financial intermediaries provide an indirect channel for the flow
of funds from savers to ultimate users. These institutions include
commercial banks, savings and loan associations, life insurance
companies, pension and profit-sharing funds and savings banks.
Their primary function is the transformation of funds into more
attractive packages for savers. Services and economies of scale
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 17
are side benefits of this process. Pooling of funds, diversification
of risk, transformation of maturities and investment expertise
are desirable functions that financial intermediaries perform.
15. Differences in maturity, default risk, marketability, taxability,
and option features affect yields on financial instruments. In
general, the longer the maturity, the greater the default risk, the
lower the marketability and the more the return is subject to
ordinary income taxation as opposed to capital gains taxation or no
taxation, the higher the yield on the instrument. If the investor
receives an option (e.g., a conversion feature or warrant), the
yield should be lower than otherwise. Conversely, if the firm
issuing the security receives an option, such as a call feature,
the investor must be compensated with a higher yield. Another
factor -- one not taken up in this chapter -- is the coupon rate.
The lower the coupon rate, the greater the price volatility of a
bond, all other things the same, and generally the higher the
yield.
16. The market becomes more efficient when the cost of financial
intermediation is reduced. This cost is represented by the
difference in interest rate between what the ultimate saver
receives and what the ultimate borrower pays. Also, the
inconvenience to one or both parties is an indirect cost. When
financial intermediation reduces these costs, the market becomes
more efficient. The market becomes more complete when special
types of financial instruments and financial processes are offered
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 18
in response to an unsatisfied demand by investors. For example,
the new product might be a zero-coupon bond and the new process,
automatic teller machines.
17. These exchanges serve as secondary markets wherein the buyer and
seller meet to exchange shares of companies that are listed on the
exchange. These markets have provided economies of time and scale
in the past and have facilitated exchange among interested parties.
18. a) All other things the same, the cost of funds (interest rates)
would rise. If there are no disparities in savings pattern,
the effect would fall on all financial markets.
b) Given a somewhat segmented market for mortgages, it would
result in mortgage rates falling and rates on other financial
instruments rising somewhat.
c) It would lower the demand for common stock, bonds selling at a
discount, real estate, and other investments where capital
gains are an attraction for investment. Prices would fall for
these assets relative to fixed income securities until
eventually the expected returns after taxes for all financial
instruments were in equilibrium.
d) Great uncertainty would develop in the money and capital
markets and the effect would likely be quite disruptive.
Interest rates would rise dramatically and it would be
difficult for borrowers to find lenders willing to lend at a
fixed interest rate. Disequilibrium would likely continue to
occur until the rate of inflation reduced to a reasonable
level.
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 19
e) Financial markets would be less efficient in channeling funds
from savers to investors in real estate.
19. Answers to this question will differ depending on the financial
intermediary that is chosen. The economic role of all is to
channel savings to investments at a lower cost and/or with less
inconvenience to the ultimate borrower and to the ultimate saver
than would be the case in their absence. Their presence improves
the efficiency of financial markets in allocating savings to the
most productive investment opportunities.
20. Money markets serve the short-term liquidity needs of investors.
The usual line of demarkation is one year; money markets include
instruments with maturities of less than a year while capital
markets involve securities with maturities of more than one year.
However, both markets are financial markets with the same economic
purpose so the distinction of maturity is somewhat arbitrary.
Money markets involve instruments that are impersonal; funds flow
on the basis of risk and return. A bank loan, for example, is not
a money-market instrument even though it might be short term.
21. Transaction costs impede the efficiency of financial markets. The
larger they are, the less efficient are financial markets.
Financial institutions and brokers perform an economic service for
which they must be compensated. The means of compensation is
transaction costs. If there is competition among them, transaction
costs will be reduced to justifiable levels.
Chapter 2: The Business, Tax, and Financial Environments © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 20
22. The major sources are bank loans, bond issues, mortgage debt, and
stock issues.
23. Financial brokers, such as investment bankers in particular as well
as mortgage bankers, facilitate the matching of borrowers in need
of funds with savers having funds to lend. For this matching and
servicing, the broker earns a fee that is determined by competitive
forces. In addition, security exchanges and the over-the-counter
market improve the secondary market and hence the efficiency of the
primary market where securities are sold originally.
